It's Time for Wall Street
To Wash Its Dirty Dishes

By

Francesco Guerrera

Updated March 5, 2012 2:17 p.m. ET

It's a concern that has crossed every restaurant-goer's mind: "Is the kitchen clean?"

Investors are no different. Seated in comfortable chairs, surrounded by the din of the markets and presented with a menu of potential purchases, they nevertheless fret about what goes on behind the scenes.

The resulting sight was less than appetizing.
Leo Strine,
Delaware's top business court judge, found a process riven with conflicts of interests and half-truths that runs counter to banks' constant refrains of being all about clients.

Mr. Strine declined to block the deal, arguing that to do so would cause more harm than good to shareholders.

But his 33-page opinion has become an instant classic on Wall Street. Coupled with other recent cases highlighting banks' conflicts of interest, it should lead financial groups to rethink how they advise on takeovers.

Here's what happened. Goldman, a long-time advisor to El Paso, had an "actual and potent" conflict in this deal, according to Mr. Strine. It owned 19% of Kinder Morgan—a stake worth around $4 billion—and controlled two seats on its board.

Goldman's response was typical. It built a "Chinese wall" between its El Paso team and the staff handling its Kinder Morgan investment and made its board nominees recuse themselves.

El Paso also hired another bank—Morgan Stanley—to work on the deal.

Goldman stepped back from advising on the Kinder Morgan takeover, although it still received credit in the industry league tables for it and is in line for a $20 million fee once the deal is sealed.

And while the takeover talks proceeded, Goldman continued to work on a competing plan for a spin-off of one of El Paso's largest divisions.

But two other potential conflicts went unnoticed. First,
Steve Daniel,
Goldman's lead banker on the El Paso team, failed to tell the company that he owned around $340,000 of Kinder Morgan stock.

That omission seems extraordinary or, as Mr. Strine puts it, "a very troubling failure that tends to undercut the credibility of [Mr Daniel's] testimony and of the strategic advice he gave."

Financial groups may well extol the virtues of Chinese walls, but what if the conflict takes place within an individual? El Paso's chief executive officer told the court he would have liked to have known about Mr. Daniel's holding because the potential conflict was not "between two divisions but between one person's brain."

Goldman said in a statement on Sunday: "We regret that the El Paso board was not aware of the investment."

That's right. The omission is regrettable because Goldman was aware of Mr. Daniel's holdings and should have told El Paso's board. (Bankers have to disclose financial interests to their firms.) For a bank whose first business principle is, "Our clients's interests always come first," Goldman fell well short.

The second undetected conflict was subtler. Morgan Stanley had a financial incentive to push El Paso to accept Kinder Morgan's approach.

Banks advising on mergers always have a financial bias towards action because they only get paid the big bucks if deals materialize. El Paso, though, had three, rather than two, options: sell to Kinder Morgan, do nothing, or spin off its division.

Morgan Stanley, however, only stood to make money if the deal with Kinder Morgan happened. Because Goldman was the exclusive adviser on the spin-off, any other outcome would have yielded "zilch, nada, zero", Mr. Strine says.

Since Mr. Daniel suggested El Paso was taking Goldman's advice on fees, the judge believes Goldman played a part in structuring the deal so that Morgan Stanley would only benefit if the transaction was consummated. Mr Strine claims that Goldman "tainted the cleansing effect of Morgan Stanley"—a conclusion Goldman disputes.

This unruly mess wouldn't have happened had Goldman resigned from El Paso right after the Kinder Morgan approach. Goldman would have probably been hired by Kinder Morgan, earned similar fees and avoided uncomfortable questions about divided loyalties.

What Goldman did isn't illegal, just inappropriate in an age in which Wall Street's morals and behavior are under the public microscope. This is no time to dance around conflicts, be cute with the legal niceties and try to have one's cake and eat it too.

Goldman and its rivals should end the suspicions over conflicts of interests by adopting a zero-tolerance approach—one major conflict and they are out of a deal—before regulators awaken to the problem.

Anything else is just a dog's breakfast that should have no place in Wall Street's kitchen.

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